It is necessary to have some idea of what can and cannot be insured and we need to note the characteristics or nature of insurable risks. There is one caveat, which should be made at this point: it is not possible or indeed wise to be dogmatic about these classifications of insurable risk. The world of business is not a static environment. It changes to adjust to circumstances as they are perceived, and what may be an uninsurable risk today could very well be insurable tomorrow. Basically there are seven characteristics of insurable risks as follows:
The occurrence of the event must be entirely fortuitous as far as the insured is concerned (the ‘insured’ is the person, company or organisation insured by an insurance company). It is not possible to insure against an event which will definitely occur, since it involves no uncertainty of loss and therefore no transfer of risk would be taking place. This would rule out inevitable events such as damage caused by wear and tear and depreciation. Any damage or loss inflicted on purpose by the insured would also be ruled out. Purposeful acts by other people would not automatically be ruled out, provided that they were entirely fortuitous as far as the insured was concerned.
The risk to be insured must result in a loss which is capable of being measured in financial terms.
In the case of property loss or damage, this is easy to see. The monetary value of property loss can be established and, subject to the terms of the insurance policy, compensation can be provided. The exact value of the loss will not be known at the outset, but only after the event has occurred. All material damage to, or theft of, property would fall into this category.
In life insurance, the level of financial compensation is agreed on at the beginning of a contract. It is impossible to place values on the life of a wife, husband or child, but the estimated financial sum assured can be determined at the commencement of the insurance.
Insurable interest can be defined as the right to insure arising out of legally recognised financial interest which a person has in the subject matter of insurance. A legally recognised financial interest is a financial interest that is recognised under the common law or statute. Thus, a person whose financial interest in the subject matter of insurance is not recognised by the law does not have insurable interest. For example, a thief could not insure the goods he stole because he does not have a legally recognised financial interest in the goods. In essence, there must be a recognisable relationship between the insured and the financial loss; if not, the insurers would not pay the compensation to the loss or damage borne by the insured.
In the absence of a large number of homogeneous exposures, the task to calculate insurance premium is much more difficult. The benefits of the law of large numbers disappear and the calculation of required premiums becomes more of a ‘guesstimate’ than a mathematical calculation. With these cases, the insurers may or may not be accurate in the setting of a premium, but inevitably will want to protect themselves by charging a premium which should cover even the worst case.
Pure risks only
Insurance is concerned primarily with pure risks. Insurance is concerned with pure risks only because most pure risks are more easily predictable. On the other hand, speculative risks are less predictable and therefore generally uninsurable.
Speculative risks are normally taken in the hope of some gain and the provision of insurance may act as a distinct disincentive to effort. For example, if it were possible to insure the profit that a person hoped to gain from an enterprise, then there would be little incentive for some people to do anything to generate the profit. No personal effort to secure the profit would still result in profit, because the policy would pay up in the event that no profit was generated.
The pure risk consequences of speculative risks are certainly insurable, but not the speculative risk itself. Take as an example the marketing of a new line of clothing. The risk that the new line will sell or not is clearly a speculative one. It is a risk knowingly entered into in the hope of financial gain. This, after all, is the very essence of business activity. However, the risks to which the enterprise is exposed: the factory in which the garments are to be made could be damaged, designs could be stolen, suppliers of essential materials could have fires or other damage resulting in them being unable to supply the raw material; all of these risks are pure risks which are insurable, but they arose directly from the decision to take the speculative risk in the first place.
Particular risks only
Particular risk is a risk that affects particular individuals, such as robbery or vandalism. It refers to those future outcomes that we can partially (though not predictably) control: it arises from individual decisions to, for instance, drive a motor vehicle, to own property or even to cross a road. We can say that those fundamental risks which arise out of the nature of society itself are usually not insurable. This would include war, changing customs, inflation and terrorism.
Not against public policy
It is a common principle in law that contracts must not be contrary to what society would consider to be the right and moral thing to do. Contracts to kill people are unacceptable, as are contracts to inflict damage on the property of people, or steal from them. It would be unacceptable to insure against the risk of a criminal venture going wrong. For example, society would not accept the idea that thieves could affect a policy which would pay them the expected gain from a theft, if they were caught by the police and therefore unable to complete the deed.
The essence of insurance is to act as a risk transfer mechanism and thus provide financial compensation for loss. Insurance does not remove the risk, but it does endeavour to provide financial protection against the consequences.
Oswald Timothy Edward is Senior Lecturer (Risk Management) at the Faculty of Business & Management in UiTM Johor.
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